I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

The Top Ten Tax Cases Of 2012, #4: S Corporation Shareholder Reasonable Compensation - How Much Is Enough?

In nearly all of the S corporation reasonable compensation cases that preceded Watson, the shareholder-employee failed to take any salary but withdrew distributions, leaving the IRS and the courts the simple task of reclassifying the distributions as compensation for services.

Because Watson actually reported compensation of $24,000 in each of the years in question, however, the Iowa District Court and the Eighth Circuit were faced with an issue of first impression: quantifying just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

IRS Approach, District Court Decision

In setting Watson’s salary, the IRS engaged the services of a general engineer, who used the financial ratios published by the RiskManagement Association to establish that based on the health of Watson’s accounting firm and the compensation of his peers in the industry, Watson’s compensation was unreasonably low.

To quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder (the MAP revealed that in general, shareholders billed at a rate 33% higher than non-owner directors), resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed with this figure, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

Eighth Circuit Decision

In reaching its decision to affirm the holding of the district court, the Eighth Circuit agreed with the lower court that that the characterization of funds distributed by an S corporation to its shareholder-employees turns on the analysis of whether the payments were made as compensation for services, not on the intent of the S corporation in making the payments. (Watson had argued that because the intent of the S corporation in making the payments was not to compensate him for services rendered, the payments could not be compensation.)

The Eighth Circuit did briefly address Watson’s argument that his reasonable compensation should be capped at the revenue he personally generated for the CPA firm, less his allocable expenses. While the court admitted that evidence of shareholder billings may be probative on the issue of compensation, the Eight Circuit ultimately refrained from adjusting the previous calculation of Watson’s reasonable compensation performed by the IRS.

In October, the Supreme Court denied Watson’s request for appeal.

What Can We Learn?

For tax advisers, the Eighth Circuit’s decision should reinforce the lessons taken home from the original Watsondecision. The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following (note, all of these considerations are discussed in much greater detail in this article published in the Tax Adviser in August of 2011).

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years. Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue (as an aside, there has NEVER been a case where the courts have reclassified distributions to salary in excess of the Social Security wage base). This approach makes sense, because once compensation equals the Social Security wage base, the payroll tax savings on the shareholder-employee’s remaining distributions amount only to the 2.9% Medicare tax.

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Great piece on what our firm sees as the most common question from our business owner clients. We can easily convey the urgency and importance of the situation to them when contributions such as yours are available. (I hope you don’t mind us sharing with them?) : ) Its great when a knowledgeable CPA can explain something in way everyone can understand. It makes our job easier. Thanks Tony. P.S. Any relation to Frank “The Enforcer” Nitti? : )